Where are the bond market vigilantes?

U.S. fiscal policy has been, in my view, somewhat irresponsible, particularly given the lack of private savings in the US. Over the past four years, the US government has shifted from a small structural surplus to a structural deficit. And the long-term deficits also has gotten worse, at least if you make reasonable assumptions about spending growth and assume existing tax cuts are made permanent.

Long-term interest rates, though, remain quite low. In part, this is because short-term interest rates remain low. But that is not the entire reason.

Let me posit one other reason: long-term interest rates have remained low because the US has not (yet) had to market many bonds to private investors.

The overall number of Treasuries in the hands of “US” market participants fell substantially between 1996 and 2000 as the supply of “marketable” Treasuries fell (as a result of budget surpluses), and then stayed constant between 2000 and 2003 despite the large increase in the overall supply of treasuries. Why? Because the Federal Reserve is holding more Treasuries as a result of its monetary policy operations and because foreigners – as we all know well – bought a lot of Treasuries. There is good reason to believe that most foreign purchases of Treasuries are coming from foreign central banks (see below). Consequently, the overall stock of Treasuries in the hands of US investors (other than the Federal Reserve Board) probably mirrors the stock of Treasuries in private hands reasonably well.

Put differently, private US investors certainly held lots fewer Treasuries in 2003 than they did in 1996 — and private investors worldwide probably did to — despite the Bush Administration’s 2002 and 2003 fiscal deficits. We don’t have full data for 2004, but the broad story likely stayed the same — at least until recently.

Let’s look more closely at what happened when the US started to run large deficits, i.e. in the 2002 and 2003, using a range of data sources, not just the Bond Market Association (BMA) data. Between the end of 2001 and the end of 2003, the total stock of marketable Treasury debt increased by $632 billion (BMA)

Japanese holdings increased by $234; China’s recorded holdings increased by $79 billion The Fed’s holdings increased by $115 billion (BMA)

Implicitly, the holdings of US market participants only had to increase by $32 billion

The US also issues “non-marketable debt,” mostly to the Social Security trust fund. The stock of this debt increased by $388 billion (Bureau of Public Debt, using fiscal year data); the holdings of the social security trustees increased by $319 billion (Trustees report).

So if the bond market has been less than vigilant, the fault, in some sense, rests with the world’s central banks. They were the ones who financed the increase in the US debt stock at current rates. The Social Security trustees are price takers, not price setters.

Why does all this matter?

Two reasons:

1. After buying roughly $170 billion of Treasuries both in 03 and 04, the Japanese government – the Ministry of Finance (MOF) and its agent, the Bank of Japan — is now out of the market. Even if emerging Asia sticks on the dollar-yuan standard and continues to accumulate $150-200 billion in reserves, the pace of global reserve accumulation is set to fall off.

2. Social security reform – whether on budget or off – will increase the supply of “marketable” treasuries. Taking 2% of the payroll tax and putting the funds into private accounts adds roughly $100 billion – and more down the line — to the amount the government has to borrow in the market.

So “partial privatization of social security” will add to the supply of Treasuries, and unless Japan resumes its intervention — or some other big players starts to intervene — there is likely to be less foreign demand for marketable treasuries going forward. And even if Japan does intervene, it may not intervene on the scale it intervened in 2003 and early 2004, when if provided $170 billion in annual demand for “marketable” treasuries. That would be true even if emerging Asia continues to informally peg to the dollar.

Treasury markets are deep and liquid. But it still seems to me that more supply and — barring a resumption of enormous Japanese intervention — less official demand will eventually translate into higher rates. For the first time since surpluses turned to deficits, the stock of treasuries in private hands will need to grow rapidly as well. Convincing private investors to shift more of their savings into Treasuries likely will require higher rates.

An aside. In 2003, we know central banks overall holdings of dollar reserves increased by $442 billion (@ $482 billion if you include the reserves China transferred to its state banks). Reported official holdings of Treasuries increased by $171, total foreign holdings increased by $290. Not all dollar reserves go into treasuries – some certainly are going into agency bonds and some are kept in deposit accounts. Some may be going into asset backed securities or even corporate bonds. But it also seems likely that the Treasury holdings of central banks increased by more than the reported $170 billion in 2003.

In 2004, official holdings have gone up by $183-184 billion (YTD), and foreign holdings by $326 billion (YTD). Take out Japan, though, and the increase looks less robust, relative to US demands for financing. Non-Japanese foreign holdings of treasuries increased by $158 billion (YTD) – a lot, but not enough to keep the stock of treasuries in private US hands from rising. That is relevant, because the US will need to fund a large deficit in 2005 and will experience a substantial drop in foreign demand for Treasuries if the Japanese don’t resume intervening in a big way.

15 Comments

Posted by anneNovember 28, 2004 at 8:17 pm

We began the secular bull market in bonds in December 1981, and prices peaked in June 2003. The decline in prices since June 2003 has been decidedly mild, almost certainly because there has been ample demand for bonds by government institutions at prices that seem very high to any sensible private investor. If as seems likely the demand for bonds from public institutions falls, we can look forward to a continued increases in long term interest rates unless the economy were to markedly weaken. Even if the economy were to weaken long term interest rates might climb if food and energy price increases hold. So, I suppose the 21 year bull market in bonds is over.

Posted by billNovember 28, 2004 at 10:53 pm

If foreign central banks, which prefer to hold US Treasuries rather than mortgage-backed or corporate bonds, were responsible for holding Treasury rates below their “natural” levels, we would have seen the spreads between Treasury yields and other fixed rates (corporates and mortgages) widen. Instead, these securities are trading at the same or lower yields relative to Treasuries than in the late 1990s.

Further, foreign central banks tend to concentrate their holdings in shorter maturity Treasuries. Their demand is not decisive in pricing the long end of the curve, the area that some think is unusually low-yielding.

The real explanation for low long term US interest rates is a combination of low inflation expectations and low real interest rates. Real interest rates in the US have declined by 2 percentage points since the Treasury first issued inflation-indexed bonds in 1997. Real interest rates in the UK, France and Japan have declined even more over the same period. Forget foreign central bank purchases of US Treasuries and focus on the reasons for the world-wide decline in real interest rates if you want to understand what’s happened and try to predict what’s next.

Posted by csgNovember 29, 2004 at 8:34 am

I thought that the central banks buy the belly of the curve and so the longer dated UST should not be affected that much by their buying.

Posted by Jeff FisherNovember 29, 2004 at 9:44 am

I expect US long term rates to soon explode.

The same rigorous economic analysis that dictated a lower dollar now demands higher rates.

It all boils down to this: the market can only consume real goods and services.

Credit is a zero sum game.

Savings from abroad are necessary for US model to keep running.

As those savings are withdrawn, only inflationary credit creation or US savings can fund US deficits.

Therefore, the choice is monetary inflation on an enormous scale (dollar collapse) or interest rates high enough to

“Economists Nouriel Roubini of Columbia University and Brad Setser of Oxford University reckon that the deficit could rise to well over $650 billion next year.”

cheers!

Posted by bradNovember 29, 2004 at 11:26 am

bill, csg —

back in 2003, was there enough supply in “belly” of the curve to have absorbed the (minumum estimate) $770 billion of official holdings (real total is probably higher) and say another $290 billion in new demand from growing reserves during the course of 2003, so by the end of 2003, $1060 billion could have been parked there by foreign central banks?

bill — there clearly have been net foreign purchases (on a significant scale) in other fixed income markets as well, though presumably more private investors/ less officials — total purchases of debt seucrities in 03 were north of $700 billion, and no more than $440 billion or so came from official sources (note that if overall $ reserves increased by $440, and foreign buying of Treasuries was max $290, some CBanks were also buying, perhaps indirectly, other fixed income assets too). but if foreigners are holding more treasuries, wouldn’t in equilibrium that also free up some of the existing stock of US savings to go into other fixed income asset classes, driving down spreads across the board (tho clearly low short-term US int. rates encouraged something of a carry trade).

appreciate your thoughts — am trying to get a grip on the fixed income market and how less foreign demand going forward will impact on it.,

Posted by bradNovember 29, 2004 at 11:26 am

bill, csg —

back in 2003, was there enough supply in “belly” of the curve to have absorbed the (minumum estimate) $770 billion of official holdings (real total is probably higher) and say another $290 billion in new demand from growing reserves during the course of 2003, so by the end of 2003, $1060 billion could have been parked there by foreign central banks?

bill — there clearly have been net foreign purchases (on a significant scale) in other fixed income markets as well, though presumably more private investors/ less officials — total purchases of debt seucrities in 03 were north of $700 billion, and no more than $440 billion or so came from official sources (note that if overall $ reserves increased by $440, and foreign buying of Treasuries was max $290, some CBanks were also buying, perhaps indirectly, other fixed income assets too). but if foreigners are holding more treasuries, wouldn’t in equilibrium that also free up some of the existing stock of US savings to go into other fixed income asset classes, driving down spreads across the board (tho clearly low short-term US int. rates encouraged something of a carry trade).

appreciate your thoughts — am trying to get a grip on the fixed income market and how less foreign demand going forward will impact on it.,

Posted by anneNovember 29, 2004 at 11:29 am

The only way round the argument that public institution purchases of Treasuries are supporting bond prices, is to believe that labor costs are going to rise at subdued rates for many years to come. Labor costs are the primary product component costs. Possibly globalization and the emergence of China and India as prime high value labor suppliers have limited and will limit labor costs increases for quite a while.

Posted by Jeff FisherNovember 29, 2004 at 11:47 am

Anne- Real wage rates are a function of the productivity of labour. Real wages can not rise without savings and investment. The effects we see all around us like falling dollar, rising gold, rising oil price, and C/A deficit are all caused by the credit boom. Interest rates are suppressed by credit boom, however they will return to natural rate (at least). Government omnipotence can not destroy the time preference of the individual or eliminate the scarcity of resources. The policies of capital consumption and inflation by the policy makers will not fool the market.

Posted by anneNovember 29, 2004 at 1:05 pm

Thanks Jeff Fisher:

Allow an argument. Wages are a function of productivity and the bargaining power of labor. Productivity growth was fine during the Great Depression, but wage growth was not fine. Similarly productivity is growing nicely now, not so wages and benefits.

Posted by Jeff FisherNovember 29, 2004 at 2:00 pm

Anne:
I emphasised REAL wages.
The government attempted to raise prices during the great depression. Wages were not allowed to fall, therefore the surge in unemployment. The unions used force and violence with the blessing of government to keep wages high. Wages had to stagnate until the inflationary policy of the FED raised nominal wage rates. However, real wage rates fell.

Furthermore, many measures were introduced to lower output and restrict imports to keep prices high. These measures prolonged the depression. Of course productivity can rise if 25% of the workforce is unemployable due to an above market minimum wage. Output per worker under those circumstances likely will increase.

Posted by Tian ZhouNovember 29, 2004 at 9:11 pm

Hello,i don’t think China can start buying Euro or the the Treasury bills of EU countries.
First, given the unprecedented level of the reserves in dollars, it will definitely incur a capital loss that exceeds the capital gain in buying Euro.
More important, will EU counries wiing to sell such bills to China? I don’t think so, for they want the euro depreciate…..
in addition, when we talk about buying assets of strategic importance, we should also consider whether it is feesible,i.e, will anyone sell it to China without another conditions? Will USA sell oil resources to China without additional terms?
i welcome your argument here, because i am a Chinese student, majoring Finance and statistics

Posted by billNovember 29, 2004 at 9:44 pm

Brad, As I understand the argument, interest rates in the US are unnaturally low because foreign central banks, not foreign investors in general, are buying Treasuries because they must, to keep their currencies from appreciating. No private investor is in a similar position, so non-CB purchasers of US fixed income securities (US or foreign)are acting out of choice. If non-CB investors believed CB purchases had made Treasuries “expensive,” they would short Treasuries and buy cheaper non-Treasury fixed income paper. In fact, the non-CB fixed income investors have bid-up non-Treasury paper (corporates, munis, mortgages and ABS) at the same rate as Treasuries have been bid up. There is no bubble in Treasury prices relative to other fixed income paper, therefore no opportunity to profit from shorting “expensive” Treasuries and buying “cheap” non-Treasuries.

It is conceivable that the CB buying has played a role in lowering Treasury real yields, but rational, discretionary private buyers have decided to bring all the rest of the world’s fixed income markets along for the ride. Unless they are behaving irrationally, these investors are confirming the inflation expectations and real yield requirements built into treasury yields.

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